Bonds signal Ireland could need more aid to avoid default
LONDON (Reuters) - Anyone in the Irish government of a nervous disposition may be well advised to avert their eyes from the bond market, where price moves indicate Ireland might need extra international aid if it is to avoid default.
Short-term Irish borrowing costs have risen sharply and could soon exceed those on longer-term bonds, creating an inversion of the normal yield curve as investors expecting contagion from Greece start to price in the possibility that Dublin might need international aid on top of the 67.5 billion euros already committed.
"A bearish flattening of the (yield) curve in the current low policy rate environment is a sign of increased stress in credit and ... a sign of the market starting to price in the risk of a default," said Gianluca Ziglio, a rate strategist at UBS.
Analysts say Irish bonds are likely to stay under pressure as a May 31 referendum on a new fiscal pact approaches and plans for Ireland to return to international bond markets are all but scuppered.
Ireland has won plaudits for its adherence to strict austerity measures, but the rise in its borrowing costs shows how vulnerable the weaker euro zone economies as a whole remain to the uncertain costs of a potential messy Greek exit from the currency bloc.
In the bond markets, yields on longer-maturity issues are usually higher because of the inherently greater riskiness of lending for longer. But when investors fear they may not get their money back, short-term borrowing rates increase faster, flattening and even inverting the yield curve.
Such abnormal moves occurred in Greek debt markets last year, before Athens received a second bailout from the European Union and International Monetary Fund.
Although Ireland's ambitious austerity drive has won it plaudits from the market, the fact that it - along with Greece and Portugal - is in a bailout programme is seen as making it vulnerable to any deepening of the euro zone's debt crisis.
Irish borrowing costs have broken above 7 percent since mid-May. Two-year yields have risen 1.5 percentage points, almost twice as much as 10-year yields since Greece's inconclusive May 6 vote sparked fears Athens could quit the euro.
Analysts expect Irish bonds to stay under pressure until a second Greek election on June 17, with short-term yields set to wipe out their differential with longer maturities, and even spike higher.
Ireland yield curve: link.reuters.com/tub48s
"Ireland will find it difficult to go back to the market for funding in these conditions," Ziglio said. "Although its problems are not the same as Greece, the market is starting to price in the probability they may need to extend the (aid) programme."
Ireland had planned to test investor appetite for short-term debt this year, before selling bonds in 2013 when its 67.5 billion euro bailout loans run out.
Its May 31 referendum on a new European Union fiscal pact is likely to increase tension and accelerate the rise in yields. The market's focus on Greece meant the risk of an Irish rejection of the pact - though slim, according to latest opinion polls - was barely priced in, some analysts said.
Polls indicate Irish voters will back the treaty, which introduces strict deficit rules, as rejection could prevent Dublin from accessing the euro zone's permanent rescue fund.
"It's going to be a very critical moment for Ireland ... The closer we approach that risk event, the more the curve is likely to invert and yields rise even more," said UBS's Ziglio.
Ireland's two-year yields had fallen to just above 4 percent and 10-year yields hit an 18-month low of 6.76 percent early this month, less than half their 2011 peaks, as markets warmed to its progress in meeting bailout targets.
The yields will need to fall to around 4 percent for two-year bonds from the current 7.13 percent and to 6 percent from 7.48 percent for 10-year debt - similar to Italian levels - before it can return to the market, strategists said.
Two-year Irish default insurance costs have risen above five-year rates, according to Markit data. Two-year credit default swaps closed on Wednesday at 756 basis points, meaning it costs $756,000 a year to buy $10 million of protection against an Irish default using a two-year CDS contract.
Five-year CDS broke above 700 bps on Monday for the first time since January and were quoted on Thursday at 716 bps.
"We've been more cautious on Ireland ... we bought two-year protection because we thought that was a good trade in terms of contagion from Portugal and from the Greek situation," said Michelle Bradley, a strategist at Credit Suisse.
While Ireland was unlikely to need a second bailout of the magnitude Greece received earlier this year, analysts said an extension of the aid package was needed given risks to Ireland's economic recovery from a worsening euro-zone crisis.
The Organisation for Economic Co-operation and Development warned in a report on Tuesday that Ireland's economic recovery risked being derailed by the fallout from the euro-zone debt crisis.
Though opinion polls show the Irish will back the EU pact next week, a "No" vote would expose Ireland to market ructions from Greece. Irish voters have twice rejected European treaties in recent years before reversing course in repeat votes.
"Assuming the vote is passed, there is a reasonable chance that the economy will require an extension of its current official programme. This is not because austerity targets are being missed, far from it," BNP Paribas analysts said.
"The broader macroeconomic economic outlook still looks very challenging," the analysts added in a note. "And it is probably not reasonable to plan on a sufficient stabilisation of market attitudes to euro zone peripherals for Ireland to expect to be able to return to the market in size in 2014."
(Editing by David Holmes)
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